Literature review

Title: credit risk management system of commercial banks

Citation: Evelyn Richard, Marcellina Chijoriga, Erasmus Kaijage, Christer Peterson,
Hakan Bohman, (2008) "Credit risk management system of a commercial bank ",
International Journal of Emerging Markets, Vol. 3 Iss: 3, pp.323 - 332
Abstract: Purpose – The purpose of this paper is to develop a conceptual model to be
used further in understanding credit risk management (CRM) system of commercial
banks (CBs) in an economy with less developed financial sector.
Design/methodology/approach – The paper reviews existing literature that consists
mostly evidence from developed countries. A study model is proposed with amendment
to fit Tanzania's environment. This is achieved through the use of both secondary
(various relevant documents) and primary (interviews) information from a CB and key
management officials dealing with credit management. The selected CB is active in
lending, has both foreign and local characteristics in its operations and has been in
operation for a relatively longer period.
Findings – The main finding of this paper is that the components of CRM system differ
in CBs operating in a less developed economy from those in a developed economy. This
implies that the environment within which the bank operates is an important
consideration for a CRM system to be successful.
Originality/value – Tanzania, a less developed economy, provides an excellent case for
studying how CBs operating in economies with less developed financial sector manage
their credit risk. The paper identifies issues to be studied further in order to establish a
CRM system by CBs operating in Tanzania.

Research methodology
1. Provide an assessment as to the quality of:
 the credit risks
 credit risk management processes
 collection process
 hedging solutions
2. Identify strengths and weaknesses within the credit risk management processes and
propose improvements
3. Propose actions that lead to reduced days of sales outstanding (DSO) and increased
cash flow
4. Present a risk portfolio model to supportgrowth strategies
5. Propose actions to mitigate credit risks
6. Targeting to deliver a win/win situation for your business by reducing the total cost of
risk and improving processes
7. Benchmark credit management against similar organizations

The manner in which credit exposure is assessed is highly dependent on the nature of the
obligation. If a bank has loaned money to a firm, the bank might calculate its credit
exposure as the outstanding balance on the loan. Suppose instead that the bank has
extended a line of credit to a firm, but none of the line has yet been drawn down. The
immediate credit exposure is zero, but this doesn't reflect the fact that the firm has the
right to draw on the line of credit. Indeed, if the firm gets into financial distress, it can be
expected to draw down on the credit line prior to any bankruptcy. A simple solution is for
the bank to consider its credit exposure to be equal to the total line of credit. However,
this may overstates the credit exposure. Another approach would be to calculate the credit
exposure as being some fraction of the total line of credit, with the fraction determined
based upon an analysis of prior experience with similar credits.

Credit risk modeling is a concept that broadly encompasses any algorithm-based methods
of assessing credit risk. The term encompasses credit scoring, but it is more frequently
used to describe the use of asset value models and intensity models in several contexts.
These include

supplanting traditional credit analysis;

being used by financial engineers to value credit derivatives; and
being extended as portfolio credit risk measures used to analyze the credit risk of
entire portfolios of obligations to support securitization, risk management or regulatory
purposes.

Derivative instruments represent contingent obligations, so they entail credit risk. While
it is possible to measure the mark-to-market credit exposure of derivatives based upon
their currentmarket values, this metric provides an incomplete picture. For example,
many derivatives, such as forwards or swaps, have a market value of zero when they are
first entered into. Mark-to-market exposure—which is based only on current market
values—does not capture the potential for market values to increase over time. For that
purpose some probabilistic metric of potential credit exposure must be used.

There are many ways that credit risk can be managed or mitigated. The first line of
defense is the use of credit scoring or credit analysis to avoid extending credit to parties
that entail excessive credit risk. Credit risk limits are widely used. These generally
specify the maximum exposure a firm is willing to take to a counterparty. Industry limits
or country limits may also be established to limit the sum credit exposure a firm is willing
to take to counterparties in a particular industry or country. Calculation of exposure under
such limits requires some form of credit risk modeling. Transactions may be structured to
include collateralization or various credit enhancements. Credit risks can be hedged
with credit derivatives. Finally, firms can hold capital against outstanding credit
exposures